What are structured products?
Structured products are an investment instrument formed with a combination of a multiple financial instruments with one or more derivatives.
So in order to understand structured product we need to understand what derivatives are.
Derivatives like the name suggest, derive their value from the underlying asset. So an equity derivative will derive its value partly from one or more of the underlying equities it represents. So some of the examples of derivatives are as follows. So derivatives can derive their value from an asset like stocks, bonds, real estate (commercial & residential), mortgages, loans and commodities. Derivatives can also be based on an index like any of the stock indices, interest rates, or currency exchange rates. Investors and institutions use derivatives to mitigate risk (hedging) of economic loss arising from fluctuations in the underlying asset value. So investors will use these derivatives either to increase profit or protect against loss. Some of the commonly used derivatives are options, futures and swaps. Generally the price the derivative is less than that of the actual asset which makes it and ideal instrument for speculation. So investors can take advantage of asset’s price fluctuations using less amount of money on the board. In a nutshell structured product can be called hybrid securities which can be used to hedge and speculate
Here are how some of the widely talked about derivatives.
Options:
Options derive their value form the underlying stocks/ index or asset. An options gives the option owner a right (but not an obligation) to buy or sell the asset at strike price and before a specified expiry. A buy option is called Call option while a sell option is called a Put option. If option is not exercised before its expiry date then its value dies down to zero. In the coming days I will devote and entire post just for these options.
Structured products are an investment instrument formed with a combination of a multiple financial instruments with one or more derivatives.
So in order to understand structured product we need to understand what derivatives are.
Derivatives like the name suggest, derive their value from the underlying asset. So an equity derivative will derive its value partly from one or more of the underlying equities it represents. So some of the examples of derivatives are as follows. So derivatives can derive their value from an asset like stocks, bonds, real estate (commercial & residential), mortgages, loans and commodities. Derivatives can also be based on an index like any of the stock indices, interest rates, or currency exchange rates. Investors and institutions use derivatives to mitigate risk (hedging) of economic loss arising from fluctuations in the underlying asset value. So investors will use these derivatives either to increase profit or protect against loss. Some of the commonly used derivatives are options, futures and swaps. Generally the price the derivative is less than that of the actual asset which makes it and ideal instrument for speculation. So investors can take advantage of asset’s price fluctuations using less amount of money on the board. In a nutshell structured product can be called hybrid securities which can be used to hedge and speculate
Here are how some of the widely talked about derivatives.
Options:
Options derive their value form the underlying stocks/ index or asset. An options gives the option owner a right (but not an obligation) to buy or sell the asset at strike price and before a specified expiry. A buy option is called Call option while a sell option is called a Put option. If option is not exercised before its expiry date then its value dies down to zero. In the coming days I will devote and entire post just for these options.
Swaps
As reflected by its name, swaps are contracts which exchange cash flows on or before a specified future date. So swaps can have an underlying asset in the form of currencies/ exchange rages, interest rates. Swaps are important as the parties selling and buying these swaps does not exchange the asset’s principal amount but profit can be derived from the asset’s price fluctuations.
Futures/ Forwards:
Futures and Forwards are contracts to either buy or sell an underlying asset on or before the future date. Unlike forwards, futures are created by the exchange on which the futures are sold.
Now coming back to the structured products
So structured products are an investment instrument based on derivatives. These are contracts issued by an investment bank promise to pay a specific payments in specified circumstances described in the contract. So the investment bank in this case will replace the usual periodic interest/ final principal payment to an investor with a non traditional payment offered to an investor based on the performance of the underlying asset. This non traditional pay off may be based on the contingency that the underlying asset returns a specified return as per the contract. Structured products are popular with investors because they can be customized for exposure in various asset classes which may not be otherwise available to the investors.
So to go into a bit more detail, a structured product will a note part and a derivative part with it. The note pays the investor an interest at a specific time interval and the derivative as discussed previously can be based on stock, bond, index etc. There is also a level of principal protection i.e. risk (full, partial or no principal protection) which brings along with it returns (less than, equal to, multiple of the underlying assets return)
As reflected by its name, swaps are contracts which exchange cash flows on or before a specified future date. So swaps can have an underlying asset in the form of currencies/ exchange rages, interest rates. Swaps are important as the parties selling and buying these swaps does not exchange the asset’s principal amount but profit can be derived from the asset’s price fluctuations.
Futures/ Forwards:
Futures and Forwards are contracts to either buy or sell an underlying asset on or before the future date. Unlike forwards, futures are created by the exchange on which the futures are sold.
Now coming back to the structured products
So structured products are an investment instrument based on derivatives. These are contracts issued by an investment bank promise to pay a specific payments in specified circumstances described in the contract. So the investment bank in this case will replace the usual periodic interest/ final principal payment to an investor with a non traditional payment offered to an investor based on the performance of the underlying asset. This non traditional pay off may be based on the contingency that the underlying asset returns a specified return as per the contract. Structured products are popular with investors because they can be customized for exposure in various asset classes which may not be otherwise available to the investors.
So to go into a bit more detail, a structured product will a note part and a derivative part with it. The note pays the investor an interest at a specific time interval and the derivative as discussed previously can be based on stock, bond, index etc. There is also a level of principal protection i.e. risk (full, partial or no principal protection) which brings along with it returns (less than, equal to, multiple of the underlying assets return)
One type of structured product is principal-protected notes (PPN). These are considered one of the safest structured products. So because this investment protects the principal, the investor buying such a note gives up the dividend yield. So normally the initial investment is invested in federally insured CDs and the rest is invested in securities which track the market indexes. So the principal get shielded and investors benefit as markets rise/ rebound.
Other example of a structured product is reverse convertible notes which are linked to a stock or a basket of stocks. These notes offer some % of downside protection but also have a cap on the upside. So if the stock doubles i.e. goes up 100%, the note may only return about 15% while if the stock tanks, these structured products offer a buffer. These are the most risky structured products. But these were the very instruments which burned investors in the current recession. Investors got burned as the underlying asset tanked and as per the contract, the investors received the tainted shares instead of getting their money back. When the stocks below a certain value (below the buffer) also known as the knock-in level, the investors will be given the lower value shares instead of the principal. So the investors now becomes an unwilling owner of those low valued stocks.
For Pros only!
Risk, return, acronyms associated with structured products can be very confusing for any naive investor. There are good reasons why a lot of investors are apprehensive about putting there money in structured products: loss of dividends, low trading volume, taxing inefficiencies and complex fee, cost and returns disclosure. Investors putting their money into structured products require a broad understanding of the actual assets, their derivatives, rate of return, risks and fees.
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